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It’s time to tighten the seat-belts and brace for a roller-coaster ride in Indian shares as a bumbling government, caught off guard by the rupee’s slump, shifts its priority to salvage the currency by tightening the availability of short-term funds.

In an unexpected move the Reserve Bank of India raised the short-term borrowing cost by a whopping 200 basis points to 10.25 per cent on Monday under a margin standing facility and initiated moves to drain cash from the banking system, both aimed at restricting speculation on the currency.

The measures spooked financial markets, sending bond yields soaring, and pulled stocks down. The rupee momentarily strengthened in the immediate aftermath but by the week’s end it remained vulnerable to another bout of weakness, suggesting there were more fundamental factors than speculation in play.

“We think that the measures, in effect, constitute a shift in monetary stance from pause to tightening,” said Tushar Poddar, economist at Goldman Sachs, adding there was a one-in-three chance for an increase in the main interest rate when the RBI reviews policy on July 30.

Clearly, for an economy expanding at its slowest pace in a decade, this is bad news. It is also a risky gambit undertaken by New Delhi that could unravel and create a bigger mess.

“RBI’s interventions to curb the rupee slide could end up constricting investment and growth,” the Indian Express said in an editorial. “The question is not merely one of monetary tightening, but also the manner in which it has been done. It comes with the pretence of not raising rates, but only tightening liquidity.”

While Finance Minister P. Chidambaram and Prime Minister Manmohan Singh tried to calm markets by stressing the measures were “temporary”

and not indicative of a shift in the long-term policy stance of the central bank, there were few takers.

“Friends, rates are headed higher... don’t let the spin doctors of the government hypnotise you to think that the higher rates are only temporary,” HDFC Securities Executive Vice President Jyotheesh Kumar said in an email to clients.

The root cause for the wobbly rupee — which has slumped more than 10 per cent since the start of May — is the waning foreign confidence in India’s ability to revive slowing growth. Ironically, the prime minister, an acclaimed economist, has presided over a disparate coalition that has been at loggerheads with itself.

Decision-making is still a major problem with the weak government, which has been wracked by a series of corruption scandals. After years of dilly-dallying New Delhi has raised foreign direct investment limits in some sectors, but these fell short of expectations and are unlikely to trigger large inflows because of the current economic situation.

Fed up with waiting endlessly for approvals, South Korea’s Posco said on Tuesday it was abandoning a $5.3 billion (Dh19.47 billion) project to build a steel mill in Karnataka state. A day later ArcelorMittal, the world’s top steelmaker, said it pulled out from a planned 12 million-tonnes-a-year steel project in Odisha due to delays in acquiring land and an iron ore mine.

India’s reliance on foreign portfolio inflow to fund its current account deficit, which stood at 4.8 per cent of GDP in 2012-13, is a risky gamble because the hot money has a tendency to head for the exit at the first whiff of trouble. What New Delhi needs to do is to facilitate foreign direct investment that is more reliable and long term.

Factory output is shrinking and while manufacturers are unable to raise prices due to sluggish demand, food and fuel inflation is accelerating. Against this grim background, the monetary tightening could make the situation worse for the economy and backfire on the rupee, which could weaken to 65 against the US dollar in the coming months.

“The current account deficit and the ability to attract long-term foreign capital inflows are still major hurdles, as is external market volatility,” HSBC FX Strategist Dominic Bunning and Head of Asian Currency Research Paul Mackel wrote in a report. “The INR may therefore remain under pressure in the medium term until these factors turn for the better.”

Citing the rupee’s fall, capital outflows, political uncertainty and a slowdown in new projects, Macquarie slashed its forecast for India’s economic growth for 2013-14 to 5.3 per cent from 6.2 per cent.

Bank of America-Merrill Lynch and Deutsche Bank also lowered their forecast for India to 5.5 per cent and 5 per cent respectively, saying their expectations for rate cuts needed to bolster investment and growth were likely to be delayed.

Surprisingly, despite the gloomy outlook the top-30 Sensex recovered from a sluggish start and rose 0.95 per cent and the 50-share Nifty index nudged up 0.3 per cent, both extending their weekly run of gains to four in a row. However, net sales by foreign funds for most of the week showed a soft underbelly.

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